VLO - Valero: U.S. Gasoline Prices Will Soar This Decade As More Refineries Shutter

2023-06-14 16:09:14 ET

Summary

• I made a well-timed bearish call on Valero last June, with the stock losing ground as crack spreads fell back toward normal levels.
• In the long-run, crack spreads will be supported by falling US and global refinery capacity - expected to decline much more quickly than renewables will grow.
• Valero is currently paying back 20% of its enterprise value through dividends, share buybacks, and debt repurchases - leaving the company much more resilient in a recession.
• Valero's most significant risks today are a recession that hampers fuel demand, or a substantial cost increase if crude oil rises due to slowing global and domestic production.
• While VLO faces immediate risks, its long-term outlook has improved and its low valuation today accounts for most of its recession-related risks.

One year ago, I published " Valero Is Overvalued As Crack Spreads Are Unlikely To Sustain Extreme Highs, " regarding my bearish outlook on the refinery giant Valero ( VLO ). Since then, the stock has declined by ~15% as the crack spread, or the difference between refined gasoline and oil prices has narrowed. The company has also faced a mild increase in operating costs, although that factor is heavily offset by its continued decline in capital expenditures.

My bearish outlook on Valero was published within days of its cyclical peak of $135. Today, the stock trades at $114, with a depressed outlook, as its forward EPS estimates decline well below its TTM level. On a TTM basis, VLO is trading at an incredibly low "P/E" of ~3.5X; however, its forward "P/E" for 2023 is 5.2X, while its 2024 earnings valuation is 8.75X. Accordingly, the market is valuing VLO as if its EPS, ultimately tied to crack spreads, will return to normal pre-shortage levels. See changes to its EPS outlook below:

I believe this situation opens the door to a potential longer-term bullish opportunity on the stock. The company is no longer valued on slightly unreasonable earnings expectations regarding crack spreads. Further, the increasingly prolonged nature of the Russia-Ukraine conflict and continued declines in refiner CapEx spending since 2022 has likely improved the fundamental outlook for crack spreads. To simplify the matter, virtually all refinery giants are reacting to the "green-energy transition" and the unstable global geopolitical and economic environment by heavily reducing their long-term investments, instead focusing on negative cash flows from financing to enhance capital stability (debt reductions, dividends, and buybacks).

Last year, I suspected this reduction would not continue. Still, since it has, refined fuel products are increasingly likely to fall into an even more significant shortage over the coming 1-5 years (or more). In the immediate term, the company could face strain from an economic downturn, particularly if combined with an OPEC cut, as that may decrease gasoline prices while increasing oil costs - directly harming Valero's income. However, from a longer-term perspective, I believe a solid bullish opportunity is forming in VLO today.

Refiners Are Giving Up Oil Refining

The vast majority of Valero's income is derived from its refinery operations. While the firm wants to expand its "renewable" segment, well over 90% of its typical income comes from oil refining. Further, the company does not own "Valero" retail locations, having sold them off some years ago. Thus, for the coming years, most of its income will continue to be tied to crack spreads, with most other factors being of comparatively little consequence. However, like its peers, the company is considering slowing its capital investments in its refinery business while expanding investments into renewables.

Its overall capital expenditure level is shallow today, implying it does not seek to expand refinery operations and is instead pursuing minimal "maintenance" capital expense levels. See below:

As you can see, Valero's situation is not unique and is closely mirrored in its peers Phillips 66 ( PSX ) and Marathon ( MPC ). All three companies have tremendously reduced capital expenditure levels while pushing "cash from financing" to significantly negative levels. These changes imply a broad shift toward returning value to shareholders instead of reinvesting profits into future operations. "Cash from financing" includes debt and equity raises (which are positive cash from financing), and dividends, equity, and debt buybacks (which are negative cash from financing). Valero's enterprise value is currently ~$49B (of which ~$41B is common equity), while its TTM cash from financing is -$9.6B, meaning the firm has essentially paid a 20% "dividend" on itself over the past year. Most of that is from a ~13% reduction in shares and a ~$5B reduction in net debt (or a ~50% decline) since 2022, while its actual dividend yield is not remarkably high at 3.6%.

Looking forward, the company will unlikely continue such immense returns to shareholders over 2023 and 2024; however, the general trend should continue to exist. Further, these changes, particularly its debt buybacks, will improve its stability in the future should crack spreads take a hit due to a recession. Most importantly, because Valero and its peers are all "throwing in the towel" on future oil refining investments, likely, the supply of gasoline in the US (and likely abroad) will deteriorate as not all operating capital (factories, etc.) is replaced.

Theoretically, the declines in gasoline supply should keep pace with increases in renewables. However, most research suggests that gasoline demand will persist near peak levels through ~2037 and continue to rise until the end of this decade. Further, those models do not indicate that gasoline demand will fall below current levels until at least 2050. At the same time, Valero and its peers are taking immediate steps to lower supply over the coming years. Crucially, an initial refinery investment takes 10- 15 years to repay itself (with that timeline rising with new regulations, increased labor and materials inflation, and interest rates).

According to Chevron's ( CVX ) CEO, this likely means no new refineries will ever be created in the US, with none built since the 1970s (meaning most today are aging quickly ). As such, the peak for US oil refinery capacity was likely hit in 2020, with that trend being mirrored worldwide . The declines in capacity have been met with generally substantial utilization of capacity; however, fuel "products supplied" remain below pre-COVID levels. See below:

Overall, the outlook for US refined product output levels is quite negative. Over the coming years, it seems likely that the US, and most countries, will see their gasoline and diesel fuel availability deteriorate. In the US, falling capacity is being made up for by high utilization; however, weather changes or other fluctuations could easily upset utilization and push available output much lower.

Of course, the outlook for US crude oil supplies is also relatively negative, potentially benefiting oil prices. US crude oil production remains below pre-COVID levels despite a significant increase in the rig count (a driver of the future output). Further, the rig count is trending lower due to low oil prices today (and rising production costs), implying that future oil production should decline. At the same time, US crude oil in storage is shallow due to the SPR release, meaning that crude may fall into very short supply should production decline without an equal drop in oil demand. See below:

In the immediate term, crack spreads remain elevated, particularly for gasoline and less for diesel. Diesel fell into extremely short supply last year, pushing prices up and lowering today's diesel demand levels. The improvement in capacity utilization has also increased distillate supplies; however, the spread is still on the upper end of its historical range. Further, the RBOB crack spread has ticked back up due to prolonged higher gasoline demand, implying that refinery output may still be insufficient. See below:

These figures suggest that Valero will continue to earn a very high margin over the coming quarters if these spreads remain elevated. While the company should not make as much as it did in 2022, its earnings outlook is still very strong, and its valuation is low, so long as crack spreads do not decline further.

Putting It All Together

Valero faces two primary risks to its 2023-2024 EPS. One is a sufficiently large recession that decreases fuel demand. The second is a significant decline in crude oil availability. Valero also faces a solid long-term catalyst of a global reduction in refinery capacity (particularly in trade-friendly Western countries), catalyzed by extremely low CapEx investing. Additionally, Valero's tremendously negative cash from financing compared to its price implies shareholders will receive a very high return on their investment.

Regarding the first risk factor, we must remember that not all recessions significantly hamper refined fuel consumption, as in the 2000 crash. In 2007, oil and gas demand declined but had fallen for years due to extremely high prices. Today, while many complain about high prices, fuel is much cheaper than in the 2000s on an inflation-adjusted basis, around 25% for gasoline and nearly 50% for crude oil of ~2005 inflation-adjusted prices. Those figures imply that crude oil and gasoline may need to rise well above the 2022 peak levels before we see a material decline in demand. Even then, outside of exogenous shocks like pandemic lockdowns, fuel consumption usually rises and declines slowly as it takes a great deal of time for people to change habits (buying more efficient cars, traveling less, etc.).

Overall, I believe the "demand-side" risk factor is not as significant as many might suspect today. That said, it seems likely that Valero could struggle with lower crude oil availability, considering today's low domestic production levels, the falling rig count (implying even lower domestic output), extremely low oil in storage (and a primarily drained emergency reserve), and yet another potential OPEC output cut. Without a doubt, uncertainty regarding Russia and Ukraine adds to a possible bullish catalyst for oil. Russia is the world's second-largest exporter, with the contentious Black Sea being a significant trade vector.

Considering these factors, there is a distinct possibility that Valero faces higher input costs over the coming year, which may not necessarily be met with more excellent refined fuel prices should the economy continue to slow. This potential creates some downside potential for Valero, which I believe is primarily offset by its lower valuation and improved solvency level. That said, I think any declines to crack spreads will eventually be met with a more significant increase due to massive underinvestment in the refinery sector, based on an apparent overestimation of the transition speed to renewables. While Valero's downside risk is notable, I believe it will likely achieve EPS near its current and TTM levels ($20-$30 - based on crack spreads) over most of the coming 5-10 years.

I am mildly bullish on VLO today and would be far more bullish should VLO decline further due to recessionary and oil availability risks. Additionally, I prefer VLO to PSX and MPC today since it trades at a ~15% discount to those two peers based on its valuation. However, most macroeconomic points are highly relevant and supportive of PSX and MPC.

For further details see: